You may have heard from some senior citizens about how they could buy necessities at nominal prices when they were young. But do you know why that is not possible now?
Over the years, the prices of goods and services rise, which reduces your buying capacity. This means that the value (purchasing power) of INR 1,000 today is lower than what it was 10 years ago and will be lower10 years from today.
What is inflation and how does it work?
Wondering what inflation is?
Well, it is the economic indicator that shows the rise in the prices of goods and services. It indicates the decline in the purchasing power of any currency and is estimated as a percent.
It is a quantitative measure that shows the pace at which the purchasing power decreases. The percentage shows the change from the previous period, and a high rate can be concerning as it indicates that the value of money is decreasing.
It is measured by the rise in prices of daily goods and services, such as consumer staples, food, transport, clothing, recreation, real estate, and much more. It calculates the average price changes over a period for specific goods and services.
What are the main causes of inflation?
One of the main causes of inflation is the rise in the quantity of money within the economy. The monetary authorities can increase the supply by printing more currency notes and distributing them in the economy.
They can also officially decrease the value of the currency. The most common method adopted by the monetary authorities is lending new money as a credit to the reserve accounts by buying government bonds from the banks in the secondary market.
When the supply of money in an economy increases, its value decreases, thus reducing the purchasing power.
The fiscal policy monitors spending and borrowing within an economy. When the borrowings increase, there is a rise in taxes, and additional currency is printed for repaying the higher debt.
Types of inflation
Based on the causes, there are three types of inflation as discussed below:
This occurs when the increase in the supply of money and credit results in a rise in the demand for products and services. The rise in demand is much faster than the production capacity of the economy and it results in an increase in prices.
As more money is available to people, they spend more on buying products and services, thus enhancing the prices. The quick rise in demand causes an imbalance in the demand-supply curve, which further leads to an increase in the prices of goods and services.
This results due to an increase in the prices of raw materials in the manufacturing process. The cost for all intermediate products rises when there is an increase in the supply of money and credit in the commodities and other asset markets.
The rise is higher if the increased supply is accompanied by a negative shock to the supply of essential products and services. All in all, the increase in the input prices results in higher prices of the finished products and services.
It is caused by the belief that the current inflation rate will continue into the future. People assume that as the prices of goods and services rise, these will continue to increase at similar rates even in the future. Therefore, they will need to spend more for fulfilling the essential requirements or earn higher incomes to sustain their current lifestyle.
The income hike increases the price of products and services, and the wage-price spiral continues to move up as one factor affects the other and vice versa.
What is the inflation rate?
Simply put, it is the percentage increase or decrease in the prices of products and services over a particular period, which can be monthly or yearly. The percentage indicates the rapid increase in the prices of goods and services during the said period.
What is the formula for calculating the inflation rate?
The formula for calculating the rate is the difference between the initial consumer price index (CPI) and final CPI divided by the initial CPI. This value is multiplied by 100 to derive the rate.
Inflation rate = (Initial CPI – Final CPI / Initial CPI) x 100
Calculation of inflation rate
You need the CPI to calculate the inflation rate. Here are the steps to calculate it.
- Determine the previous and current prices of the product
- Use the formula (Initial CPI – Final CPI / Initial CPI) x 100, where CPI is the product’s initial price
This will give you the percentage increase or decrease in the product’s price during a particular period, which can be used for comparison purposes.
Effects of inflation
- The purchasing power of money reduces as the prices for goods and services rise, which impacts the cost of living
- As prices increase, the cost of living also rises, resulting in a slowdown in the country's economic growth
- Domestic products may become less competitive in the global markets due to higher prices
- Companies may have to lay-off personnel to control wage expenses, which increases unemployment
Even though there are some negative effects of inflation, a certain increase is required. This ensures people do not hoard money and spend it to buy goods and services.
How is inflation measured in India?
In India, there are two indices in which this economic indicator is calculated; Wholesale Price Index (WPI) and Consumer Price Index (CPI). WPI measures the changes in the wholesale prices whereas the CPI measures changes in the retail prices.
CPI calculates the difference in prices of products and services like foods, electronics, medical care, education, and others.
In comparison, WPI determines the changes in the prices of goods and services sold by businesses to smaller ventures to sell these further to other buyers.
Who benefits when inflation rises?
As the prices increase, consumers witness a decline in their purchasing power; however, investors benefit from it.
When you put money in assets that are affected by such changes and hold them over the long term, you can enjoy a lot of benefits.
For example, rising prices may affect homebuyers; however, if you have invested in a property, you will benefit from the increase.
How should you protect yourself from inflation?
Building wealth over the long term requires disciplined savings. So, it is recommended you put aside a certain amount each month from your income.
To begin with, you must understand the impact of taxes and inflation on investments. It is advisable to invest in assets like real estate, stocks, and others that increase in value over the long term.
You may avoid short-term or cash investments while building a portfolio.
Keep a check on expenses
Reduce your expenses and avoid buying things with supply imbalances resulting in price increases. Additionally, fixing interest rates on your debts can act as a hedge against future increases.
Frequently Asked Questions (FAQs)
What is the meaning of inflation?
It is the gradual decrease in the purchasing power of money and is a quantitative measure of this decline expressed as the average increase in the prices of selected goods and services.
Are there any benefits of inflation?
Yes, investors benefit from the increase in the prices of products and services. When you put money in assets that move in line with the inflationary increase and stay invested for the long term, you can benefit from a higher rate of return.
How can inflation be prevented?
The simplest way to prevent it is by changing the monetary policy to modify the interest rates. Higher rates decrease the demand and slow down the economic growth, which curbs inflationary rise.
Other methods include controlling the supply of money in the economy, increasing the income tax rates to reduce expenses, and implementing strategies that boost the country's efficiency and competitiveness in the long term.
What are the types of inflation?
Based on the causes, the three types are demand-pull, cost-push, and built-in inflation.
How can you calculate inflation?
The formula is (Final CPI/Initial CPI) x 100
Can gold be used to hedge against inflation?
Yes, as the inflationary pressure increases, the currency tends to lose its value, which results in an increase in the price of gold.
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